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Paulson Plan May Not Fly with HFs, Investors

Date: Friday, December 7, 2007
Author: Emma Trincal, HedgeWorld

WASHINGTON (HedgeWorld.com)—The subprime mortgage interest rate freeze plan presented Thursday [Dec. 6] by President George W. Bush may be a tough sale for hedge funds and bondholders who hold the securities backed by those loans. Treasury Secretary Henry Paulson was the main sponsor of this plan.

By temporarily freezing interest rates on some subprime loans before those rates are to reset to higher levels, the new measure will have a potential negative effect on the revenue stream of some of the investors in these securities, experts said. And in all likelihood, hedge funds with long positions in those bonds will bear the cost of the new plan.

"The assumption is that the reset of subprime interest rates will lessen the losses for the bondholders over the long run. But there is no way to know if this is going to be the case," said Ryan Atkinson, chief market analyst at Balestra Capital Partners LP, a New York-based hedge fund that posted substantial returns by shorting mortgage assets. "In my guess it won't."

The plan, known as "Hope Now," has been pitched as a way to prevent the U.S. economy from falling into a recession next year. Mortgage foreclosures hit a record high in the third quarter, posing a threat to consumer spending. The rate increase moratorium is seen by some as at best a public relations move from a government under political pressure approaching an election year. Worse still, some view it as a dangerous form of moral hazard that could perpetuate the financial crisis because freezing rates creates an artificial security mechanism that interferes with market forces.

"It may help a few people. But it won't stop home prices from falling," said Mr. Atkinson. In the meantime, he said, the plan is negative for the bondholders, as they will lose the income they were supposed to receive from higher interest rates.

"Those adjustable-rate mortgages are only profitable for bondholders if they can get excess interest after the teaser rate or if they can get a prepayment penalty," said Mr. Atkinson. "That's how those bonds are designed. Without one or the other, bondholders or banks will be the losers."

What the plan will do for hedge funds "will depend on their position," said Mr. Atkinson. "If you're short, it's better for you."

As presented and leaked to the media over the past week, the plan was not designed to be a gift to investors. Rather, its main purpose was to help subprime borrowers on the brink of foreclosure by freezing their adjustable mortgage loan rates for a period of five years. It will cover adjustable loans set to reset as early as next year for loans taken out from January 2005 through the end of July this year. The plan is expected to provide relief for 1.2 million homeowners representing the part of the subprime market with the worst credit history.

For the plan Mr. Paulson conducted talks negotiated with the American Securitization Forum, the securitization lobby group on Wall Street, the mortgage servicers and the lenders.

Critics of the plan argued that its impact will be limited. The number of subprime borrowers that will benefit represent only about 1% or 2% of some 150 million U.S. homeowners.

"Roughly 50% of loan modifications end up defaulting at some point anyway," wrote Paul Miller, mortgage analyst at Friedman, Billings, Ramsey & Co. Inc. "Any loan modification plan can add stability to the market, but it cannot fix a stressed-out borrower in an overvalued home."

Democrats also found the new measures insufficient, saying the plan is doing too little too late. In a statement, Sen. Chris Dodd (D-Conn.), chairman of the Senate Banking Committee, called the new housing proposal "an agreement that amounts to little more than financial wallpaper."

Other critics looked at the negative impact for banks and the securities industry. The plan could drive securities underwriting business away from the United States, said Dick Bove, financial analyst at Punk Ziegel & Co. who is particularly critical of a plan. He said it is "destroying the nation's financial credibility. . . . [It] is raising questions as to whether the United States is committed to maintaining the credibility of its financial markets." He added that a growing number of investors are likely to move their business overseas as a result of this market disruption. More importantly, Mr. Bove predicted that the plan will cause banks' earnings to plunge.

For analysts, including Mr. Bove, who don't buy into the idea that a recession is looming for the United States next year, the Paulson plan is economically questionable. "Not only has the economy not fallen into recession in the first half of this year, it is actually growing well above trend," Mr. Bove said.

He noted that the current housing downturn is caused by a glut of housing on the markets that could take five to seven years to eliminate. "No adjustment in mortgage rates is going to get rid of this glut," he said.

One of the most important aspects of the debate on this new housing plan is its implementation. "How are you going to determine who is not going to be able to make payment on the reset?" said Mr. Atkinson. "They're trying to streamline the process but it's going to end up being on a case by case basis."

"I am very interested in the plan because I don't have a clue as to how it will work legally," said Sylvie A. Durham, hedge fund lawyer at Greenberg Traurig LLP, in an email interview.

Ms. Durham said that once mortgages have been securitized, banks do not have the authority to freeze the rates on those mortgages. "I've noticed that there is absolutely no detail provided with this ‘plan,'" she wrote.

Another tricky feature, she added, is the issue of the swap counterparties on these deals, who swap fixed payment in exchange for floating payments. "They didn't sign up for a deal where the floating payment is going to be capped for a period of time," she said. "Since many of these swap counterparties are foreign banks, I don't see how any U.S. legislation can change the deal that they entered into."

Due to the lack of clarity of the new measures, Ms. Durham concluded that "It's impossible to know whether this is good or bad for the industry."

Finally, the plan raises some issues as to whether it is fair to other borrowers that have made their payments. They, unlike the home buyers with poor credit histories, will not benefit from the interest rate freeze.

Some anticipate a surge in lawsuits, especially from investors. But Mr. Paulson said during the press conference that "the risk of litigation should be manageable" because the new standards are the products of discussions among investors and servicers.

Others argued that the plan is more of a political scheme than a serious effort to contain the risk of recession. After all, it is happening just before an election year and during the holidays.

"Loan modification does not help struggling subprime borrowers, only the politicians of both parties who prey upon them," wrote Christopher Whalen, senior vice president and managing director at Institutional Risk Analytics, a risk management and advisory firm based in Los Angeles, in a recent blog entry. "Loan modification a la Paulson hurts investors, financial institutions and the U.S. economy."

A more balanced view shows that it may not be all that gloomy for bond investors and banks as benefits or pain will depend on depend on which level of risk, or tranche, the investor holds.

"The plan is not necessarily going to hurt the revenue stream for all bondholders. It will depend on the particular securitization tranche they own," said Ronald Greenspan, senior managing director for the corporate finance practice at Baltimore-based FTI Consulting. FTI is a global advisory firm that provides consulting services to organizations confronting legal, financial and bankruptcy issues and advises many of the major mortgage company restructurings occurring right now.

The lower the credit rating of the tranche, which includes equity and junior tranches, the more the investor might be hurt.

"The plan will likely help many of the senior bondholders," said Mr. Greenspan. He explained that in many cases, as much as 90% of the bondholders own senior tranches and get a fixed interest rate. "What they make is not influenced by the rate of interest the borrowers pay but by the number of defaults," he said. In that regard the plan, by limiting the number of foreclosures, is a positive for them.

"For them, the rate reset brought up by the plan will not be detrimental. If you have a trust that issues 90% of senior tranches at a 7% rate, these certificate holders are going to continue to get their 7% as long as there is any money in that trust."

On the other hand, hedge fund managers who invest in the riskiest tranches may be the main casualties as they take on the first losses. "The hedge funds are likely to bear much of the costs of this program," said Mr. Greenspan. That's because hedge funds tend to own the bonds that get wiped out first. "Those are the bonds that are the most exposed by the rates reset," he said.

Overall the economic impact of the plan remains unclear. The plan may not hurt investors all that much, however its benefits for economic growth and the housing market continue to be vague.

"If it was not in an election year, this plan would not be happening. It's not economically driven. If it was, the servicers and the industry would be doing it on their own," Mr. Greenspan said.